Thursday, January 24, 2008

The Economist and Benign Deflation

I had the privilege today of meeting Zanny Minton Beddoes, the economics editor for The Economist magazine. She was a presenter at at a regional economic outlook conference held in nearby Austin, Texas. Her part of the program was to deliver an assessment of the national economy. She did a great job describing the major shocks that have recently hit the U.S. economy--high oil prices, frozen credit markets, housing market bust--and the potential outcomes of these shocks. After her talk, I was able to chat with her for a few minutes. Among other things, I complemented her and The Economist for taking seriously the implications of benign deflation for the U.S. economy during the 2003-2005 period. As I have argued before, the Fed's misreading of the 2003 deflationary pressures as being malign when in fact they were benign led to an overly accommodative monetary policy at that time. As a consequence, interest rates were pushed far beneath their neutral level and the stage was set for the biggest housing boom-bust cycle in U.S. history. The Economist recognized this was happening and was one of the few observers sounding the alarm over this development (Andy Xie was another, see here). Only now are other observers (here, here) beginning to see how prescient The Economist was in its calls to reign in monetary policy during this time. It was a real treat, then, for me to meet Zanny, and briefly discuss these issues with her.

In case you missed The Economist's coverage of benign deflation and its implications for the U.S. economy during the 2003-2004 period, I have posted below an edited version of an article that appeared in 2004.

From The Economist print edition

A new paper questions whether inflation will really turn out to be America's main economic problem... Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble... Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.

High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government...

[T]he second piece of evidence [can be seen in] what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit...

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid.

If you want more, see Unnaturally low.


  1. Since 2002 at the blog PrestoPundit -- using the economics of Friedrich Hayek -- I've been saying all these same things about benign deflation and the housing bubble, etc. Through the lens of Hayek's microeconomic conception of macroeconomics, all of this was obvious.

    It's reassuring to see that I wasn't alone in blowing the whistle on Greenspan and Bernanke.

  2. So, we'll see how benign deflation is when corporate debt, government debt and personal debt are a records. Hayek? I like Hayek. Those holding debt are on the Road to Serfdom. A great Hayek book.

  3. PrestoPundit:

    I got my introduction to the idea of benign deflation from works of George Selgin and the folks at the BIS (Claudio Borio, Andrew Filardo, William White). They take the view that while benign deflation is consistent with robust economic growth, malign deflation is a real threat to economic activity and should be actively offset by monetary policy. This understanding seems reasonable to me.

    My impression of the Austrians, however, is that while they love to sing the praises of benign deflation, they fail to take seriously the dangers of malign deflation (e.g. the Great Depression deflation was appropriate). Is this assessment correct?

  4. David -- A number of Austrian macroeconomists do take seriously the dangers of malign deflation. Steven Horwitz, for example, has a discussion of malign deflation in his book, _Microfoundations and Macroeconomics: An Austrian Perspective_. He's got some articles published on the topic as well.

    Even Hayek was aware of the problem -- he called the possible malign deflation phase of the boom - bust cycle a "secondary depression".

    Hayek, in his early career when he worked on macroeconomics, didn't have the data on the Great Depression we have today. His guesses as to what happened in the 1930s relied upon what turned out to be false empirical assumptions, assumptions which only began to be corrected with the work of Milton Friedman, many years later.

  5. Prestopundit:

    Thanks for the reply. I will take a look at Steven Horwitz's work.

  6. David - ever since the start of the GFC I've been trying to find a copy of King's paper from 2004 that you quote in this article, but I can't find it anywhere.

    (Alex Tabarrok actually referred me to your blog after I referred the same economist article to him.)

    Do you have a link to the paper?

  7. Will Derwent:

    I am not aware of any links, but I do have copy of the paper. I can email to you if you wish. You can reac me at david[dot]beckworth[at]